Empirical Analysis on the Causal Connection between Money Supply and Stock Prices in India

Sarbapriya Ray

Stock market is a crucial ingredient of the financial system of any economy as it plays a fundamental role in channelizing savings from deficit sector to surplus sector. Money supply, whether it is unanticipated or anticipated by people, is one of the component of monetary policy that reserve bank of India (as central bank) uses, affects the stock market. This study aims to examine the long run and causal dynamic relationships between the money supply and stock prices in India using the time period 1990-91 to 2010-11 for India. The cointegration test confirmed that money supply and stock prices are cointegrated, indicating an existence of long run equilibrium relationship between the two as confirmed by the Johansen cointegration test results. The Granger causality test finally confirmed the presence of bi-directional causality which runs from money supply to stock prices and vice-versa. Regression result suggests that money supply has positive significant effect on stock prices in India. The effect of money supply on stock prices is statistically significant with the appropriate sign. This signifies that increase in money supply leads to increase in liquidity available for buying securities that eventually results in upward movement of nominal equity prices and vice versa. Future studies to be conducted by the prospective researchers in this particular area of financial economics would suppose to include more comprehensive indices to capture the effect on stock prices through change in money supply.

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